Cost conundrum: Super funds, fees and private equity

When Australian motorcycle dealership MotorCycle Holdings went public last year, The Growth Fund – previously known as Archer Growth – returned more than half of the A$46.3 million ($36 million) raised to its investors. Since then, the company’s shares have risen to more than double the IPO price, giving the private equity firm’s remaining 10% holding a valuation of A$16.4 million.

In this context, the A$4.1 million in IPO costs, most of which was paid to the bankers, lawyers and accountants who helped make the transaction happen, seems relatively insignificant. But they represent one of a string of costs that The Growth Fund’s superannuation fund LPs must include in the management expense ratios (MERs) that are central to their marketing efforts, under proposals from the Australian Securities & Investments Commission (ASIC) intended to deliver greater fee transparency.

Private equity is already regarded as expensive by an industry that has become highly sensitized to fees: it might account for 5% of a superannuation fund’s portfolio but eat up half of the overall MER budget. Rolling more costs into the PE share of the MER, especially if other asset classes are not treated in the same way, exacerbates this problem. Regardless of the difference MotorCycle Holdings makes to The Growth Fund’s overall performance, re-ups could become harder for those super funds to justify.

Introducing the MER structure the way they have is essentially reintroducing prescriptive investment, whereby the signal from the regulators is that you should invest in index funds – John Peterson

“The way the regulation is framed at the moment creates a number of anomalous outcomes and a number of fictions that don’t reflect accurately the true cost of investing into a particular investment strategy,” says Yasser El-Ansary, CEO of the Australian Private Equity & Venture Capital Association (AVCAL). “This would present challenges to superannuation funds continuing to support allocations to the asset class, an outcome that neither the super funds nor us would want to see. And the end result is less money invested in Australian businesses.”

Long time coming

The regulation – known as RG97 – has been a long time coming. The publication of the Cooper Review report in 2010 threw the spotlight on superannuation fees, saying they were too high, and the government responded with MySuper, a low-cost default option. Conscious that members could switch programs at short notice, superannuation funds have been under pressure from their trustee boards to lower MERs ever since. Management fees are seen as a cost that should be reduced, not the price one pays for access to superior managers who can deliver a higher net return.

“RG97 clarifies some of the uncertainty around what to include in fees and costs. Previously there was a degree of interpretation around how some of those fees were reported. Now there is less scope for interpretation,” says John Peterson, speaking in his capacity as an independent researcher under the Peterson Research Institute (he is also illiquids portfolio manager at Local Government Super). “The major problem with RG97 is that it defines the price for purchasing the stream of returns from active manager skill as a cost. It is the only investment treated in this way.”

No one is opposed to greater consistency in terms of what information is disclosed, thereby allowing superannuation members to compare fees and costs across funds more easily. Rather, there are concerns that the proposals as they stand fail to meet the objectives: there is likely to be inconsistent reporting due to uncertainty about implementation of the requirements; and comparisons will be difficult because different asset classes are not being treated equally.

As a result, the compliance deadline, originally set for February, has been pushed back to October but it remains to be seen how successful the various industry groups will be in lobbying for change. While private equity is just one of multiple asset classes affected, the list of problems presented by RG97 is long and complex.

The planned inclusion of IPO costs in MERs is the result of ASIC’s view that the portfolio companies in which a private equity fund invests – not the fund itself – should be considered the ultimate investment made by a super fund. “This is nonsense, because when you commit to a private equity fund you don’t know what assets will be acquired,” says one PE manager at a super fund. “We argued that these funds are making control investments so you can’t say the end investment is an unlisted company.”

However, by establishing the portfolio company as the starting point, RG97 requires super funds to include every cost incurred from there up through all the different layers of a private equity investment structure in their calculations. Line items that might be considered normal costs of doing business, including fees paid to intermediaries who play a role in bolt-on acquisitions as well as in IPOs, should therefore end up in the MER.

“If a listed Australian company were to engage in the very same type of M&A activity and incurred the same type of costs there is no requirement to disclose that sort of information through to the listed equities fund manager who then discloses that to the superannuation fund. That is where a typical disconnect starts to emerge clearly,” says AVCAL’s El-Ansary. “There is an apples and oranges comparison taking place rather than apples and apples.”

Any indirect cost a super fund might have previously excluded from the MER because it doesn’t constitute a fee paid to the manager would have to be included. A further issue is with fee offsets – where a private equity firm provides a service to a portfolio company that would otherwise have to be outsourced to a third party, and then rebates this against fees paid by LPs. Some of these costs could end up being double counted.

For example, if a GP charged an annual management fee of $10 million but also received a $1 million fee from a portfolio company for providing a particular service, it would only call $9 million from its LPs that year to reflect the offset. However, under the current interpretation of the RG97 proposal, the GP would have to report $11 million in fees in its MER.

More broadly, several characteristics of the private equity fee model do not translate well into the one-size-fits-all approach envisaged in by ASIC. They include: the drawdown style of investment; the way in which management fees are fixed during the investment period and then progressively decline for the remaining life of a fund (before being distributed back to LPs prior to managers receiving carried interest); the innate lumpiness of carried interest; and the lack of a standardized approach among LPs towards elements such as backdated management fees, equalization interest and clawbacks.

These are cited by AVCAL in its submission to ASIC as grounds for using a whole fund life or a medium-term average in MER calculations in order to give a clearer picture of what is happening inside a fund. In contrast, fee calculations for listed equities are typically based on the current market value of an initial one-off investment – an approach that does suit the RG97 proposals.

It is difficult to say by how much MERs might increase as a result of the changes due to variances in portfolio composition, but estimates industry participants made to AVCJ range from 30-60 basis points. For context, AustralianSuper charges total fees of 0.12% for its public equities and fixed income-heavy index diversified pre-mixed option, 0.64% for the balanced option, and 0.73% for the high growth option. Balanced and high growth have private equity allocations of 4-5%, while index diversified has zero.

Margin for change

A finalized regulation would need to be in place by May or June so that super funds can complete their preparations ahead of the implementation deadline. For private equity alone, the burden is daunting. “Every fund has a different investment structure and the effort required to collect the cost of all those different levels is enormous,” says Geoff Sanders, a partner at Allens. “The principle sounds right but implementation is difficult. It will take years to work out all the kinks and get some level of consistency.”

In the interim, the industry groups would like to see clarifications that push MERs closer to what they see as the true costs of participation in various asset classes. Asked what he would consider a positive outcome, a second PE manager at a super fund says: “There is some validity to what ASIC is doing but they’ve gone a bit too far. Anything that represents a wind back from the current position would be beneficial.” However, he sees no fundamental turnaround on regulation that has been three years in the making.

Nathan Hodge, a partner at King & Wood Mallesons, shares this view, noting that it is too late for the private equity industry to get a hearing on its argument that too much weight is placed on cost and not enough on returns. “The regulator says net returns are important but you can’t just ignore the building blocks of net returns,” he says. “The measure is drafted very broadly and so the best that can be hoped for is plugging some of the holes in a way that is favorable to private equity but within the confines of the broader requirements in relation to RG97.”

If these changes do represent a consolidation of the regulatory authorities’ seemingly intractable stance on superannuation fees, the question lurking in the background concerns what the industry will look like five years from now. PRI’s Peterson draws comparisons with the 1970s when there was a requirement for 30% of capital to be deployed in fixed interest investments. Come 2022, banks and a handful of mega super funds may dominate an industry in which the emphasis on fees encourages wholly passive, low cost strategies.

“Introducing the MER structure the way they have is essentially reintroducing prescriptive investment, whereby the signal from the regulators is that you should invest in index funds,” Peterson says. “Eventually the prescriptive investment approach of the 1970s was seen to be very distorting in respect of the allocation of capital and creating lower returns to superannuation investors, and it was removed. The same thing will happen to the current prescriptive regulatory regime. However, a lot of damage could be done before then.”

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• Topics
• Australasia
• Regulation
• LPs
• Fundraising
• Australia
• AVCAL
• Australian Securities & Investments Commission (ASIC)